How to piggyback on the M&A surge

After a six-year lull, deal making is back with a vengeance. That means investors may need to rethink strategies to profit from increasing numbers of mergers and acquisitions.

Warren Buffett’s Berkshire Hathaway and Brazil’s 3G Capital Partners said on Thursday they would buy ketchup-maker H.J. Heinz for $23 billion, the same day AMR Corp and US Airways agreed to a merger worth $11 billion.

These deals came a week after a group of shareholders led by company founder Michael Dell announced plans to take computer maker Dell private in a $24 billion buyout, and Liberty Media announced a $15.75 billion deal for British cable group Virgin Media.

Just in the past 24 hours, shares of Office Depot Inc and smaller rival OfficeMax Inc have soared on rumors that the two are in advanced talks for a merger that could be announced this week.

Deals are up 10.5 percent to $288 billion this year from the same period last year, according to Thomson Reuters data. Last year, global M&A rose just 2 percent to $2.6 trillion.

Analysts do not expect the value of this year’s deals to top the $4 trillion mark, as in 2007, mergers and acquisitions values should nonetheless jump significantly higher, thanks to a combination of low interest rates, high levels of cash on corporate balance sheets, and rising stock prices that give company executives the confidence to take risks.

In a slow-growth economy, companies are also seeing it as a quick way to increase profits, and sometimes eliminate competitors, rather than invest in new operations of their own.

“I’m pretty negative about the market in general in 2013, but the one thing that could upset my hypothesis is M&A, because you have the perfect storm of conditions” for a rally, said Uri Landesman, president of New York-based Platinum Partners, with more than $1 billion in assets under management.

Mature companies with declining growth rates and lots of cash look to buy smaller companies to raise their earnings, which could push share prices higher as investors bid up the companies in potential deals, Landesman said. What’s more, cash-rich companies such as Apple have been targeted by activist investors for hoarding their dollars and not creating enough value for shareholders.

Investors who want to focus on mergers and acquisitions have two main options: play it safe with an arbitrage strategy, or make a bet that they can identify the next takeover targets.

The easiest way to benefit from potential mergers and acquisitions is through an arbitrage mutual fund or exchange-traded fund, analysts said.

These funds buy shares of the target company after an announcement while shorting the purchaser as a hedge in case the deal falls apart. This strategy tends to make money for investors as the spread between the deal price and the current stock price narrows.

Investors rarely benefit from the pop in a share price once a deal is initially announced. Instead, this route is more akin to fixed income investing, where earning a positive return is the primary goal.

“People are starting to dip their toes back into the equity markets, and this is one way of doing it while focusing on capital preservation,” said Willis Brucker, an analyst who works on the $616 million Gabelli ABC fund, which charges a fee of 62 cents per $100 invested.

The fund, which turns over its portfolio five or six times a year as deals close, also benefits from rising interest rates faster than an intermediate bond fund because there is little inflation risk, he said.

Because of their focus on capital preservation, arbitrage funds tend to underperform the broad stock market. The Gabelli fund’s 4.6 percent annualized return ranks among the top five funds among its 19 peers over the last decade, according to Morningstar, though its performance trails the S&P 500 index by 3.7 percentage points over that time. The fund also underperformed the Vanguard Total Bond Market Index fund by 0.3 percentage points over that span.

Investors could also opt for the IQ Merger Arbitrage ETF. The fund’s assets are only $12 million, giving it a relatively high bid-ask spread of 0.87 percent. Its track record, an annualized 0.1 percent over the last three years, is spotty compared with the broader S&P 500 over the same time.

“The merger concept was just not resonating with investors at all” after the financial crisis, said Adam Patti, the CEO of IndexIQ, the company behind the ETF. The fund, which costs 76 cents per $100 invested, is up 2.1 percent since the start of 2013, compared with a 0.6 percent rise in the average market neutral fund.

Investors looking for potential takeover targets could go to published lists from the likes of Morningstar, which includes Chesapeake Energy Corp, Leap Wireless International, and Kohl’s Corp among its 2013 takeover ideas.

Some financial firms publish their own versions as well. UBS includes luxury retailer Burberry Group PLC, information technology company Legrand SA, and grocer Sainsbury PLC on its European “M&A Watch” list.

The downside of this method is that simply appearing on the Morningstar list, which has included more than 70 companies in each of the last two years, often leads to a rally in shares. So if you fail to act the moment the list is released, you may pay more for a stock that fails to attract takeover bids.

For instance, six companies that appeared on the Morningstar list in 2011 saw their stock appreciate by at least 17 percent between the time the list was published and the time they accepted takeover deals.

This year, Kohl’s is up 4 percent since Morningstar published its list Jan. 29, more than double the performance of the S&P 500 over the same time. The company’s strong cash flow and growth potential makes it attractive to private equity investors, Morningstar noted.

A more lucrative bet for investors is to screen for small to midcap companies with cash on their balance sheets and good levels of free cash flow. These are the metrics that private equity investors look for when deciding to make a deal, said Brian Frank, portfolio manager of the $14.9 million Frank Value Fund, who looks for takeover targets as part of his strategy.

“Private equity funds love to borrow money and then have a company pay off that debt, which is very difficult to do if it already has a lot,” he said.

Frank began his position in True Religion Apparel Inc , a $715 million market cap company behind the high-end brand True Religion Jeans, in August.

He was attracted to the company because of the cash on its balance sheet, which at one time amounted to 40 percent of its market cap. In October it announced it was putting itself up for sale and while it has not disclosed any bids, Frank expects True Religion to be acquired for about $35 per share, a 25 percent premium from its current price.

Small-cap fund managers insist they don’t focus on takeover targets alone when buying a stock. Bruce Aronow, a portfolio manager of the $1.2 billion AllianceBernstein Small Cap Growth fund, expects a handful of the roughly 100 companies in his portfolio to be acquired in any given year.

To become part of his portfolio, a company must be growing earnings faster than consensus estimates. That strategy has helped his fund return an annualized 12.5 percent over the last 10 years, or 4.2 percentage points ahead of the S&P 500.

“We like companies that are on their way to becoming large quickly, and those are the companies that tend to get bought out,” Aronow said.

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